Conflicts of interest; rating given to a CDO will determine whether it is created – if the CDO is created, the ratin agency will be paid for its ratings

Ultimately, rating agencies may have to do more to address the conflicts of interest implicit in their business models, reported The Australian Financial Review (20/9/2007, p.69).Agencies rate the hand that feeds them: Although S&P, Moody’s and Fitch effectively act as agents for investors when they analyse and publicly rate a security, they are paid by the banks and investment banks that are structuring the security to sell. The fees can be in the hundreds of thousands of dollars per rating. The inherent conflict of interest is the risk that the agent will act in the interests of those who are paying him.

Conflict even greater with CDO ratings: Rating agencies hold a “uniquely powerful position” in the CDO market, says Andrew Davidson, founder of a New York-based fixed income consulting firm of the same name, because the rating given to a CDO will determine whether it is created. A CDO vehicle buys assets and issues debt just like a financial institution. If the rating agency gives a rating that allows the CDO vehicle to borrow money at a low enough rate or at high enough leverage, then the CDO can purchase assets more competitively. If the CDO is created, the rating agency will be paid for its ratings. “There are very few institutions that can remain objective given such a compensation scheme,” says Davidson.